Milton Friedman Prize Lecture

M. Friedman

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apparent tendency for an acceleration of inflation to. reduce unemployment.

That can be explained by the impact of 

unanticipated 

changes in nominal de-

mand on markets characterized by (implicit or explicit) long-term commit-

ments with respect to both capital and labor. Long-term labor commitments

can be explained by the cost of acquiring information by employers about

employees and by employees about alternative employment opportunities plus

the specific human capital that makes an employee’s value to a particular

employer grow over time and exceed his value to other potential employers.

Only surprises matter. If everyone anticipated that prices would rise at,

say, 20 percent a year, then this anticipation would be embodied in future

wage (and other) contracts, real wages would then behave precisely as they

would if everyone anticipated no price rise, and there would be no reason for

the 20 percent rate of inflation to be associated with a different level of unem-

ployment than a zero rate. An unanticipated change is very different, especially

in the presence of long-term commitments-themselves partly a result of the

imperfect knowledge whose effect they enhance and spread over time. Long-

term commitments mean, first, that there is not instantaneous market clearing

(as in markets for perishable foods) but only a lagged adjustment of both

prices and quantity to changes in demand or supply (as in the house-rental

market); second, that commitments entered into depend not only on current

observable prices, but also on the prices expected to prevail throughout the

term of the commitment.

3. STAGE 2: NATURAL RATE HYPOTHESIS

Proceeding along these lines, we [in particular, E. S. Phelps and myself (4),

(22), (23)] developed an alternative hypothesis that distinguished between

the short-run and long-run effects of unanticipated changes in aggregate nomi-

nal demand. Start from some initial stable position and let there be, for ex-

ample, an unanticipated acceleration of aggregate nominal demand. This will

come to each producer as an unexpectedly favorable demand for his product.

In an environment in which changes are always occurring in the relative

demand for different goods, he will not know whether this change is special to

him or pervasive. It will be rational for him to interpret it as at least partly

special and to react to it, by seeking to produce more to sell at what he now

perceives to be a higher than expected market price for future output. He will

be willing to pay higher nominal wages than he had been willing to pay before

in order to attract additional workers. The real wage that matters to him is

the wage in terms of the price of his product, and he perceives that price as

higher than before. A higher nominal wage can therefore mean a lower 

real

wage as perceived by him.

To workers, the situation is different: what matters to them is the purchasing

power of wages not over the particular good they produce but over all goods

in general. Roth they and their employers are likely to adjust more slowly their

perception of prices in general - because  it is more costly to acquire information

about that - than their perception  of the price of the particular good they

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Economic Sciences 1976

produce. As a result, a rise in nominal wages may be perceived by workers as a

rise in real wages and hence call forth an increased supply, at the same time

that it is perceived by employers as a fall in real wages and hence calls forth an

increased offer of jobs. Expressed in terms of the average of perceived future

prices, real wages are lower; in terms of the perceived future average price,

real wages are higher.

But this situation is temporary: let the higher rate of growth of aggregate

nominal demand and of prices continue, and perceptions will adjust to

reality. When they do, the initial effect will disappear, and then even be re-

versed for a time as workers and employers find themselves locked into inappro-

priate contracts. Ultimately, employment will be back at the level that pre-

vailed before the assumed unanticipated acceleration in aggregate nominal

demand.

This alternative hypothesis is depicted in Figure 2. Each negatively sloping

curve is a Phillips curve like that in Figure 1 except that it is for a particular

anticipated or perceived rate of inflation, defined as the perceived average rate

of price change, not the average of perceived rates of individual price change

(the order of the curves would be reversed for the second concept). Start from

point E and let the rate of inflation for whatever reason move from A to B and

stay there. Unemployment would initially decline to U

L

. at point F, moving

along the curve defined for an anticipated rate of inflation

of A. As

anticipations adjusted, the short-run curve would move upward, ultimately

to the curve defined for an anticipated inflation rate of B. Concurrently un-

employment would move gradually over from F to G. [For a fuller discussion,

see (5).]

This analysis is, of course, oversimplified. It supposes a single unanticipated

change, whereas, of course, there is a continuing stream of unanticipated

changes; it does not deal explicitly with lags, or with overshooting; or with the

process of formation of anticipations. But it does highlight the key points:

what matters is not inflation per se, but unanticipated inflation; there is no

stable trade-off between inflation and unemployment; there is a “natural rate

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